Investing in commercial real estate is a relationship business. Investors will often first look to the investment returns, but the most important component of any real estate syndication is inarguably the sponsor (also called the syndicator or general partner) who is leading the deal. It's very important to analyze the deal sponsor from multiple aspects to ensure there's a fit between your need and the syndicator’s strategy.
As part of a deal sponsor team that has done close to 20 syndications with 7 different sponsors, I wanted to provide framework utilizing our experience vetting syndicators. Before we jump in, it's important to understand that all deals – regardless of industry, asset or strategy – center around three key components:
1) Deal
2) Market
3) Sponsor/Syndicator
In an ideal scenario it would be great to "knock it out of the park" on all three components but we strongly believe the last item – sponsor/syndicator – plays the most significant role. A good commercial real estate sponsor can turn around a mediocre deal, but a bad one can definitely tank a good deal.
Since the sponsor is the one making all of the management decisions and responsible for executing the business plan, let's focus on the framework for analyzing the sponsor.
Background & Team
Investors can find out general information from the sponsors’ website, which will often include their investment philosophy, acquisition criteria, and portfolio of their prior projects.
First impressions matter. Does the syndicator interact professionally and consistently across the board – meetings, online presence (website, social media), offline presence, communications?
What is the investment strategy? How is it presented?
Are they focused on a specific niche where they have developed expertise or a competitive advantage?
How is the team structured? What role is each partner playing? We prefer teams with cross-functional abilities but clearly delineated roles. One individual should not be wearing too many hats nor spreading themselves too thin.
Do the key partners (KPs) have their bios listed along with their experience? Has, at least, one partner (preferably more) been through more than one market cycle? if so, how was their performance through the entire business cycle?
What is the tenure of the KPs? There are exceptional managers with long tenures working with new sponsors. We do not see this as a problem. This is a relationship driven business where skills are transferable
What/how is the syndication team’s online and social media presence? Reputation matters – a lot. Do a quick Google, LinkedIn and social media search to better understand all KPs in a real estate syndication team. We are looking for honest, high integrity folks with stellar character.
Who have they worked with before?
How is their reputation within the community and industry?
What do the referrals say about them?
Track Record & Investing Strategy
One way to build your trust is to find out what experience the sponsor has. Does the company have a track record that you can review? How many deals have they closed? How many deals have they exited? You can also find out the specifics of each deal they have done by reviewing their portfolio. This information is often included in the investment offering and/or on their website.
You want to see consistency in types of projects they are investing in. (Example: do they only do large value-add class B apartment properties or are they all over the place A/B/C/D including other niches like storage, etc. or strategies like turnarounds, momentum plays, etc.) The simpler more consistent strategy is best. You get very good at focus.
Can the syndicator concisely articulate the investment strategy?
How confident is the sponsor in their strategy?
Performance - Ideally, you’d like to see evidence of returns (cash on cash %, growth in NOI, consistent distributions especially if there is a preferred return) at or above the original business plan forecasts and within industry expectations. As of writing, at this stage of the real estate cycle, conservatively underwritten, large multifamily value-add deals are averaging between 8%-10% cash on cash returns and 15%-20% IRR over a five-year hold. If I see a deal promising 15% cash on cash return and 25% or higher IRR I get a little nervous. We like to see sponsors conservatively underwrite deals that under-promise and over-deliver.
Investor Relations
Availability - Does the Sponsor have time for you? Do they make themselves available to answer your questions and educate you?
You should be able to talk to the sponsor directly.
You should be able to ask the sponsor just about any question and they should be able to answer you promptly with a quality response.
Are you comfortable with their responses? Do they help educate you on technical areas? Sponsors want to have long term relationships with their investor so if they are not answering you could get a sense that they are not thinking long about this business and where does the limited partner (investor) sit in this relationship. You want to feel like you're an equal partner. You should be well informed and very comfortable with your investment and how you are treated and communicated with.
Can you tour the property? If an investor wants to see the property, I’ll line that up with the property manager and meet them as well, if possible.
Communications Schedule - A good sponsor should give you an example of an investor communications schedule and some correspondence on past deals for you to review. The schedule should contain frequency of communications, timing of distributions and K-1 statements for tax purposes, how you can contact the sponsor and other handy tips.
Conservative Underwriting / Assumptions and Forecasts
This might be one of the most important points, cannot overemphasize that a good sponsor should be principled in being conservative in their numbers and assumptions that make up the business plan and investment performance projections.
Words like “capital preservation” and “conservative underwriting” should come out loud and clear on the company website, any projects you are reviewing, etc. It’s not rocket science but a lot of common sense. The business model in value-add apartment investing with experienced sponsors is quite attractive financially so there is no compelling reason to embellish the numbers or stretch. You can conservatively post numbers that gain investor attention and interest and pleasantly surprise them during the duration of the investment with upside performance. Why take risks in forecasting higher numbers and then struggle to meet them consistently.
Every deal you analyze you will want to review the sponsor’s assumptions carefully. Commercial real estate sponsors should provide sensitivity analysis alongside the financials. These should be accompanied by commentary on the major drivers – vacancy, rent upside, loan terms and exit valuation. This allows the investor to map out the best, medium and worst-case scenarios to determine if the deal is a good fit for their portfolio.
Here’s an example of how a sponsor might take different assumptions. We bought a property where 25% of the units were already renovated and the previous owner was getting $100 more in rent across all size apartment units (studio, 1x1, 2x2, 3x3). The market comps around us for renovated units were about $115-$125 more per unit. The company underwrote the deal at $71. That’s a nice spread, from $71 to $125. The market can go soft and you can still make good money for the investor at $71. More aggressive might be to assume $100 and even more aggressive, assume $115 to $125 and show your investor a greater return. Not a good idea. Always want to under-promise and over-deliver so be conservative. Same with occupancy. Submarket was at 97%, we were at 95% upon purchase, but we underwrote to 90% year one and 93% thereafter. Our sensitivity analysis showed even if the market had a melt down and we got 81% occupancy, we still yield 6% to the investor in a market meltdown and be profitable.
Sponsor / Limited Partner (Investor) Payout Structure
Review the payout structure and understand how the sponsor and you the investor gets paid for distributions, refinances and sales.
Return conversations should focus on net returns only. The sponsor must be able to walk an investor from gross returns to net returns by explaining the impact of all expenses and fees. The investor is trying to understand the flow of distributions. How do the investor and sponsor split distributions? Cross-reference this with the waterfall structure.
What is the anticipated timing of fees and returns? What frequency will they be incurred and paid – monthly, quarterly or annual?
We believe that a properly structured waterfall aligns everyone’s interests. A waterfall is where a certain hurdle rate must be reached before the sponsor can split profits with the investors. Coupled with a preferred rate this establishes a floor below which a sponsor will not make any returns. As of writing common waterfall profit splits range between 20-40% (sponsor) and 60-80% (investor), preferred range between 8-10%.
Preferred Return – I personally like to see a preferred return in the deal. This favors the investor. There is no guarantee when you invest in these deals, however, the next best thing to a guarantee for the limited partner is a preferred return. Typical preferred return is 8%. What this means usually is that any distribution, refinance or sale that creates cash to the investor, the first 8% (to equate to an 8% cash on cash yield) will be paid to the limited partners and the sponsor gets nothing until we exceed that threshold. Above 8%, then the payout reverts to the split agreed to of say 70% to the investor and 30% to the sponsor.
Sponsor Fees / Investor Alignment
Fee structure: each sponsor will have different fee structures which will be outlined in the investor subscription documents or private placement memorandum. As an investor, look for structures that show the sponsors’ interests are aligned with the investors.
The first two are very common fees, the others are optional:
Asset Acquisition Fees: (1-3% of the purchase price of the apartment paid to the sponsor at closing). This is for all the work the sponsor goes through to find just this one great property but having to look at, analyze over 50 to 100 to get to this one and all the work leading up to the close including taking care of the staff, administration, analyst, marketing, etc. It’s a onetime fee. I can live with 2%.
Asset Management Fee: (1-3% of the monthly revenues generated by the apartment) paid out usually quarterly to the sponsor. This is primarily to cover the costs and time associated with ensuring the apartment management company executes the business plan. Again, I see 2% as common.
Loan Guarantees: – Sometimes you will see this because the lender requires one or two of the key sponsors to put up their net worth as collateral to the size of the loan. So specific folks on the sponsor team want to get paid to take on that burden / risk even if non-recourse loans are common (as carve out rules usually apply).
Disposition Fees: Average 1% of sales price. These are paid to the sponsor to compensate for the costs related to selling an asset. Often it is an optional fee.
Refinance Hurdle: Average 2%. These compensate a sponsor for creating additional value such that when a refinance is done a sizable portion of the investor capital is returned. We prefer the return of capital to be in the 40-80% range. For the investors this is tax efficient return of capital. The refinance is treated as a return of capital and not a return on capital. Hence, it is not taxed as an income/profit distribution.
Sponsor Investment Commits: – I like to see a sponsor invest in their own deal. I’m not hung up on how much that really is but I’d like to see it be at least the minimum for an investor. If most of the partners on the sponsor team are putting up money I feel better. Now, I know a lot of sponsors who don’t and that would not preclude me from investing with them. Why? Because as a sponsor, there is a ton of work involved, skill and knowledge and experiences that are brought to bear to make this a great investment, often termed “sweat equity”. Having the sponsors put more of their own money in the deal from a symbolic standpoint is a good thing but you shouldn’t expect them to be betting the ranch with their personal funds.
Additionally, I know a sponsor who put together 6 deals in the past 12 months and I can tell you his financial planner would not be advising him to invest his own money in every deal, at least not much, because he like you should be thinking about his overall financial picture. This is akin to folks who used to put all their 401K money in their company stock. Probably not too smart if you have your livelihood (salary / bonus) already in the deal which the sponsors essentially have as most are pursuing this on a full-time basis. Again, it shows alignment with the other investor partners and that in general is a good thing but don’t get hung up on it. Once you have been a commercial real estate sponsor you will realize they earn it.
Investment Duration and Exit Strategies
Understanding the investment duration allows an investor to better determine if an asset is a good fit from an asset-liability match perspective. This also helps in understanding if an investor is being adequately compensated over the duration of the investment.
It is important to map out exit strategies before an investment is made. An investor should understand a sponsor’s Plan B, C and D as to understand possible courses of action that can be taken if things go awry.
Property Management
In acquisition mode, it is considered best practice to hire a professional property manager (PM). The PM team ensures that the operational plan is executed in a timely manner. It is the duty of the sponsor to manage the PM.
The sponsor must:
Review the property PM team
Run background check
Determine how many units the PM is currently managing
Bigger is not always better
Verify the track record of the PM including history in the sub-market where the asset is being acquired
Ensure that the PM team manages a similar class/type of property as the one being acquired
PM teams specializing in Class D properties will not be a good fit for Class A properties
Tour their other properties to get a better idea of their management style
Verify references
Good PMs focus on creating a community atmosphere. Numerous studies have shown that this increases tenant engagement leading to better care of the property by the tenants as well as lower vacancy. This also creates a more harmonious tenant/landlord relationship.
It is important to take note of qualitative impacts as they have quantitative effects.
Asset Management
The sponsor is responsible for overall asset management and being an effective steward of investor’s capital.
We like to understand the key plans and how they will be implemented in managing the asset efficiently.
A key facet of asset management is communications. We prefer sponsor teams to provide regular communications. In this business, over communication is preferred. The communication does not have to be extensive. It could be as simple as a few bullet points outlining operational details, major wins (and losses) and how issues are being handled.
The point of regular communications is to make the investor aware of how the sponsor is working with the property manager to address current and emerging issues.
References
I get asked for references from time to time by investors considering their first investment with us and am more than happy to provide to investors. I usually seek out an investor or two who have been in our deals longer and in a couple of investments. I try to provide different references so I don’t overburden anyone of our investors but I think it helps and investors who do this extra step seem to like it.
You may want to ask questions like:
How have the investments performed vs. projections?
What has the sponsor promised but not delivered?
What has the sponsor promised and delivered?
What is the communication frequency?
How does the sponsor handle unforeseen issues?
In Summary
An investor should always seek to work with commercial real estate sponsors who are a good personality fit. Initially, this can be hard to observe but using our framework and asking the right questions, an investor can get deeper insights and feel more comfortable moving forward.
In the end, it is all about forming holistic relationships with win-win solutions. Once you've found a great sponsor, you can usually reduce a lot of this due diligence work on future deals and continue to ride with them…focusing more on the market and projects they are presenting to you. Once sponsors find a philosophy, model and formula that works, it's usually consistently repeated over and over. Everyone – sponsors, investors, tenants, property managers, lenders, brokers and the community – should come out as a winner.